Operating and Financial Leverage Chapter 5 McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline What is leverage? Break-even analysis Operating leverage Financial leverage Combined leverage Potential profits or increased risk?

What is Leverage? Use of special forces and effects to magnify or produce more than normal results from a given course of action Can produce beneficial results in favorable conditions Can produce highly negative results in unfavorable conditions

Leverage in a Business Determining type of fixed operational costs Plant and equipment Eliminates labor in production of inventory Expensive labor Lessens opportunity for profit but reduces risk exposure Determining type of fixed financial costs Debt financing Substantial profits but failure to meet contractual obligations can result in bankruptcy Selling equity Reduces potential profits but minimizes risk exposure

Operating Leverage Extent to which fixed assets and associated fixed costs are utilized in a business Operational costs include: Fixed Variable Semivariable

Break-Even Chart: Leveraged Firm

Break-Even Analysis The break-even point is at 50,000 units, where the total costs and total revenue lines intersect Units = 50,000 . Total Variable Fixed Costs Total Costs Total Revenue Operating Income Costs (TVC) (FC) (TC) (TR) (loss) (50,000 X $0.80) (50,000 X $2) $40,000 $60,000 $100,000 $100,000 0

Break-Even Analysis (cont’d) The break-even point can also be calculated by: Fixed costs = Fixed costs = FC Contribution margin Price – Variable cost per unit P – VC i.e. $60,000 = $60,000 = 50,000 units $2.00 - $0.80 $1.20

Volume-Cost-Profit Analysis: Leveraged Firm Table 5-2

A Conservative Approach Some firms choose not to operate at high degrees of operating leverage More expensive variable costs may be substituted for automated plant and equipment This approach may cut into potential profitability of the firm

Break-Even Chart: Conservative Firm

Volume-Cost-Profit Analysis: Conservative Firm Table 5-3

The Risk Factor Factors influencing decision on maintaining a conservative or leveraged position include: Economic condition Competitive position within industry Future position – stability versus market leadership Matching an acceptable return with a desired level of risk

Cash Break-Even Analysis Deals with cash flows rather than accounting flows Helps in analyzing the short-term outlook of a firm Examples of noncash items that are excluded: Depreciation Credit sales Credit purchase of materials

Degree of Operating Leverage (DOL) Percentage change in operating income as a result of a percentage change in units sold Computed only over a profitable range of operations More when it is computed closer to BEP DOL = Percent change in operating income Percent change in unit volume

Operating Income or Loss

Computation of DOL Leveraged firm: DOL = Percent change in operating income = $24,000 X 100 Percent change in unit volume $36,000 20,000 X 100 80,000 = 67% = 2.7 25% Conservative firm: DOL = Percent change in operating income = $8,000 X 100 Percent change in unit volume $20,000 = 40% = 1.6

Algebraic Formula for DOL DOL = Q (P – VC) , Q (P – VC) – FC Where, Q = Quantity at which DOL is computed P = Price per unit VC = Variable costs per unit FC = Fixed costs For the leveraged firm, assume Q = 80,000, with P = $2, VC = $0.80, and FC = $60,000: DOL = 80,000 ($2.00 - $0.80) ; 80,000 ($2.00 - $0.80) - $60,000 = 80,000 ($1.20) = $96,000 ; 80,000 ($1.20) - $60,000 $96,000 - $60,000 DOL = 2.7

Limitations of Analysis Assumption of existence of constant or linear function for revenues and costs as volume changes May not hold good in real world Price weakening to capture increasing market Cost overruns when moved beyond optimum-size operation Relationships are not so fixed as assumed

Nonlinear Break-Even Analysis Assumption of exact linear relation does not hold good in reality

Financial Leverage Reflects the amount of debt used in the capital structure of the firm Determines how the operation is to be financed Determines the performance between two firms having equal operating capabilities BALANCE SHEET Assets Liabilities and Net Worth Operating leverage Financial leverage

Impact on Earnings Examine two financial plans for a firm, where $200,000 is required to carry the assets Total Assets = $200,000 Plan A (leveraged) Plan B (conservative) Debt (8% interest) $150,000 ($12,000 interest) $ 50,000 ($4,000 interest) Common stock 50,000 (8000 shares at $6.25) 150,000 (24,000 shares at $6.25) Total financing $200,000 $200,000

Impact of Financing Plan on Earnings per Share Table 5-5

Financing Plans and Earnings per Share

Degree of Financial Leverage DFL = Percent change in EPS Percent change in EBIT For the purpose of computation, it can be restated as: DFL = EBIT . EBIT – I DFL for two plans can be calculated using values from Table 5-5 Plan A (Leveraged): DFL = EBIT = $36,000 = $36,000 = 1.5 EBIT – I $36,000 - $12,000 $24,000 Plan B (Conservative): DFL = EBIT = $36,000 = $36,000 = 1.1 EBIT – I $36,000 - $4,000 $32,000

Limitations to Use of Financial Leverage Beyond a point, debt financing is detrimental to the firm Lenders will perceive a greater financial risk Common stockholders may drive down the price Recommended for firms that are: In an industry that is generally stable In a positive stage of growth Operating in favorable economic conditions

Combining Operating and Financial Leverage Combined leverage: when both leverages allow a firm to maximize returns Operating leverage: Affects the asset structure of the firm Determines the return from operations Financial leverage: Affects the debt-equity mix Determines how the benefits received will be allocated

Combined Leverage Influence on the Income Statement Last item under operating leverage, operating income, becomes the initial item for determining financial leverage “Operating income” and “Earnings before interest and taxes” are one and the same, representing the return to the owners before interest and taxes are paid

Combining Operating and Financial Leverage

Operating and Financial Leverage Table 5-7

Degree of Combined Leverage Uses the entire income statement Shows the impact of a change in sales or volume on bottom-line earnings per share DCL = Percentage change in EPS ; Percentage change in sales (or volume) Using data from Table 5-7: Percent change in EPS $1.50 X 100 $1.50 = 100% = 4 Percent change in sales $40,000 X 100 25% $160,000 =

Degree of Combined Leverage (cont’d) DCL = Q (P – VC) , Q (P – VC) – FC – I From Table 5-7, Q (Quantity) = 80,000; P (Price per unit) = $2.00; VC (Variable costs per unit) = $0.80; FC (Fixed costs) = $60,000; and I (Interest) = $12,000. DCL = 80,000 ($2.00 – $0.80) = 80,000 ($2.00 - $0.80) – $60,000 – $12,000 = 80,000 ($1.20) = 80,000 ($1.20) – $72,000 DCL = $96,000 = $96,000 = 4 $96,000 – $72,000 $24,000